Financial markets

Investing

Timing the market

Feb 6th 2013, 17:09by Buttonwood

COMMON sense and historical evidence suggest there are moments when equities are cheap and it is possible to snap up bargains, and there are times when shares are expensive and it is best to sell. But while it is easy to spot these moments in retrospect (e.g. 1999), can it be done at the time?

Several valuation tools look useful; the cyclically-adjusted price-earnings ratio, the Q ratio (replacement cost of net assets), even the level of real interest rates. In their report this week, the London Business School team of Elroy Dimson, Paul Marsh and Mike Staunton look at the price-dividend ratio (cyclically-adjusted), the inverse of the dividend yield. They divide US history into five buckets; those years where the ratio was below 14 (i.e. the yield was over 7%), the ratio was 14-21 (5%-7%), 21-28 (3.5%-5%), 28-35 (3%-3.5%) and over 35 (below 3%).

When the ratio was below 14, investors subsequently earned an average annual real return of more than 10% over periods ranging from 1-10 years. When the ratio was above 35, as it is now, investors earned real returns of well below 5% a year. The evidence is even more clear in the UK.

But apply this rule to the whole world over the last 113 years and the evidence is much clear; the correlation between the cyclically-adjusted dividend yield and subsequent equity returns is just 4%.

Even this result has the benefit of hindsight. As the professors point out, a statement that assets will perform badly once they have reached the top of their historical valuation range, and well when they have touched the bottom, is a truism. Investors do not know the full valuation range until they have reached the end of the period and by then it is too late. We now know that the Shiller p/e ratio of 44.2 in 1999 was the top of the range but we did not know it at the time. Indeed, had we used the Shiller p/e we would have sold quite early since the ratio's previous peak had been 32.6 in 1929.

So the professors used a market-timing model based on information that investors would have known at the time, starting back in 1920. The model required investors to sell equities and out the proceeds in cash, every time that future real returns looked low. Sadly, this model was a complete flop; in every single market (out of 20), the approach generated a lower return than investors would have achieved had they just used a buy-and-hold strategy and stuck with equities.

Ah well. It is perhaps inevitable that there is no easy way to time the market; otherwise, it would have been discovered, exploited and eliminated before now. Neverthless, the evidence that future returns are likely to be low from here, just based on fundamentals, is still very strong.